• Automobiles Sector Valuation Methodology

    Automobile sector is one of the most important sectors in one economy which is again divided into different segments based on different categories like

    1. Passenger car
    2. Luxury cars
    3. Heavy vehicle like buses and trucks
    4. Commercial Vehicles
    5. Utility vehicles including tractors
    6. Two Wheelers and Three wheelers

    While analyzing one Auto Sector Company a financial analyst should consider some important Points and key terms which we will discuss here. Here we will also mention the key terms and points and the key financial and operational parameters used to evaluate an automobile sector company.

    Key points about Telecom Sector

    Sales Volume

    The main source of revenue comes from the sales of cars and vehicles so sales volume is the main indicator of the total revenue earned by an auto sector company. Analysts should look at the sales number to analyze an automobile company. The higher the sales number, better the company’s financial health.

    High Sales and Administrative Expenses

    As the automobile sector is highly competitive, the auto sector companies have to invest heavily for sales and marketing to increase the sales volume. The importance of building the brand identity and brand awareness is huge in this sector compared to other sector as there are no significant product level differences among same type of products. Proper sales and marketing spending lays the foundation for future growth.

    Dependence of GDP and Per Capita Income

    The demand for passenger cars depends solely on the GDP and Per Capital Income of the economy as people will buy cars only when their average income grows significantly. GDP per capita is already very high in the developed economies which lead to lower growth in the auto sector while in the emerging economies the auto sector is witnessing a double digit growth due to high growth in GDP and per capita income.

    The co-relation between the GDP and Per Capita Income with the auto sector growth is very high. An analyst should look at the projected GDP growth to analyze the revenue growth projection of an auto sector company.

    Inflation and Interest Rate

    Most of the car and vehicle sales are done on loans and credit. That’s why interest rate plays a major role in determining the demand for cars and vehicles. The interest rate also depends on the inflation. An analyst should look at the interest rate scenario and inflation of the country to analyze the future demand of cars and vehicles. Also high inflation increases the raw material cost which also affects the profitability of the auto sector companies.

    Product Line

    Product line of the auto company and the level of competition in that particular segment are very much important while analyzing an automobile sector company. The competition also increases significantly with the number of players in that particular segment.

    Market Share

    With the sales volume, market share in particular product segment is also an important parameter to analyze an auto sector company. High market share in particular product segment gives an auto company the dominant position in that particular segment and the other players follow it for any kind of price and strategy related decision making. Analysts should also look at the market share to analyze the financial health and valuation of an auto company.

    Competition and Innovation

    For every kind of product line there is an intense competition among different players and players are doing continuous innovations and launching new cars to keep the market shares intact. The competition level and capability of innovating new technologies continuously drive the growth and help to retain the market share. The more capable an auto company is in innovating new technology and launching new products, the growth prospect is better.

    Distribution Network

    Proper distribution network is an important requirement to increase the sales volume. Most of the sales is done through dealers and showrooms and companies have to set up proper servicing network to provide better services to the existing customers. Companies having selling and service network only in cities can not sell cars and vehicles in the rural areas. An analyst should check the selling and distribution network of an auto sector company to project the sustainable sales volume growth in future.

    Key Operational and Financial Parameters

    Operational Efficiency

    As for the auto companies the inventory cost is very high, one of the most important parameter is the operational efficiency. Japanese auto majorToyotais famous for its lean production system or Just in time (JIT) production system which enables them to reduce any loss in inventory and increases the profitability. Operational efficiency is a key parameter used to evaluate an auto sector company.

    Management

    As the Auto sector is very much competitive and technology oriented, the long term growth and performance depends on the Management’s vision and credibility. Formulating the right strategy at the right time is very much important to sustain the business growth here. An Analyst should check the long term vision and credibility of an auto company while assessing its value and projecting its future growth.

    As workers’ union is very common in the auto sector, management’s credibility is very important to engage all the workers properly in work to keep the manufacturing activity smooth.

    Sales Growth

    As the sales volume base is the main parameter to denote the growth of an auto sector company. An analyst should look at the total sales volume and market share to do valuation of an auto company.

    Gross Profit Margins

    As the auto sector companies invest heavily to procure inventory and cost of goods sales is very high, gross Profit Margin is considered to be the main profitability ratio. Gross Profit Margin is calculated as

    Gross Profit Margin (%) = (Gross Profit /Total Revenue) * 100

    Where, Gross Profit = Revenue – Cost of Goods sold

    Higher Gross Profit Margin denotes better efficiency of the company in generating high profit with low inventory expenses.

    Debt to Equity

    The auto companies use to take high debt to fund the initial investment requirement to conduct Research and Development and set up manufacturing plant which is normally very high. The initial investment requirement is funded by debt and the interest is paid from the income. So the Debt-to-Equity ratio is a key financial ratio which should be used to evaluate an auto company. It is calculated as

    Debt-to-Equity Ratio = Total Debt / Total Shareholders’ Equity

    Lower the Debt-to-Equity, better the financial health of the company as lower debt results in lower interest payment from the profit.

    Return on Equity

    Return on Equity is also as an important financial parameter to evaluate the performance of an auto company. This is mainly due to high equity investment. This is calculated as

                Return on Equity = Profit after Tax (PAT)/Equity or Net worth

    Higher return on equity denotes better profit realization for an auto company.

    Valuation Ratio

    To do the valuation of an auto company’s market share mainly the Price to Sales (P/S) price multiple is used instead of other popular price multiples. Sales revenue can not be manipulated easily as it is tracked by the government for the sales tax realization on each unit of sales.

    Because of very high initial investment, depreciation etc, earnings and book value can be manipulated easily for the auto sector companies. That’s why P/E Ratio and P/BV Ratio are not widely used for the auto sector companies.

    So P/S is used as an important price multiple to compare the share price of an auto company with other peer group companies. Higher P/S ratio compared to other peer group companies denotes the market share price as overvalued while the lower P/S ratio denotes the market share price as undervalued.

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